Why we welcome a return to negative equity-bond correlation

Equities and bonds: the building blocks for diversified portfolios 

At a basic level, Nutmeg portfolios are built through bonds and equities accessed via ETFs which offer a high level of flexibility. The allocation across each asset class is determined by our investment team, based upon our clients’ time horizon, and an assessment of their attitude to risk.  

Historically, the mix between equites and bonds has worked well due to diverging cycles of performance of those two asset classes, alongside factors such as liquidity and volatility. This essentially means that at any particular time, as one might be performing poorly, the other might be doing well. They are characteristically very different.  

Typically, equities will tend to perform better during positive economic growth cycles; as companies’ earnings increase this is often reflected in their share prices. Conversely, it makes sense then that the shares of many companies suffer or underperform during periods of low growth or even economic contraction when earnings are down.    

On the other hand, bonds (the term fixed income is often used as well) tend to perform well during periods of lower growth, and even during recession in developed markets. Why is this? Typically, during those more challenging economic environments, central banks, which are confronted with lower growth and falling economic output, cut their headline base interest rates to support economic activity. Inflation tends to be less of a problem during economic weakness and that works in the favour of bonds as inflation is generally the nemesis of bond valuations. 

These lower base rates often translate into lower yields for long-term (10-year plus) bonds, and as bond yields fall, bond prices go up (bond yields and price work inversely). Therefore, bonds can act as a ‘shock absorber’ during those periods, providing support to multi-asset portfolios during times of lower returns from riskier asset classes like equities.  

Equity and bond correlation in charts 

Equity and bond correlation is a key feature in terms of the diversification of multi-asset portfolios. Chart 1 below, shows the performance of bonds during each given decade.  

Chart 1: Average bond performance during negative equity markets 

Time Series: MSCI World Equity Local and US ICE BofaML. Source: Nutmeg, Macrobond 

In the three decades prior to 2020, during negative periods for equities bonds inversely tended to perform positively.  

However, Chart 1 also shows the Covid period (2020 to 2022), where bonds also lost some value. Bonds did not play their normal shock absorber role. This positive correlation created difficulties for multi-asset portfolios, especially in 2022.

Interestingly, more recent performance so far in 2023 (while we acknowledge the data sample is limited) shows bonds potentially reverting back to their role as an equity loss diversifier (negative correlation). 

Chart 2: Bond vs equity correlation (6 months, weekly data) 

Based on weekly returns with 6 months lookback. Time Series: MSCI World Equity Local and US ICE BofaML. Source: Nutmeg, Macrobond 

Chart 2 shows bond and equity correlation over more than 20 years, and it shows that positive correlation is indeed the exception rather than the rule. Remember, positive bond-equity correlation is when bonds and equities both follow the same relative performance, both high or low at the same time. 

Backing up the findings from Chart 1, the level of correlation in 2023 so far is back to a more typical pattern of negative bond-equity correlation. The diversification effect is expected to prevail, with bonds once again a core support of multi-asset portfolios. 

How inflation impacts equities and bonds 

In the post-Covid period from 2020 to 2022, the main likely reason that we saw a positive correlation between bonds and equity, diverging from the long-term norm, was the rapid increase in inflation and the subsequent policy response from central banks around the world.  

Traditionally, bond markets often react negatively to rising inflation expectations. This is because as monetary policy is shifted to tackle higher inflation with higher interest rates, bond yields increase and so bond values fall.  

The impact of inflation on equities tends to be less dramatic. However, as we saw in 2022, when inflation significantly overshot market expectations, monetary policy was tightened more abruptly than initially anticipated, causing unwelcome equity market uncertainty and loss.  

Higher bond yields can also make equities a less attractive proposition versus fixed income from a risk premium perspective, adding difficulties to corporate financing and equity valuations. 

However, as it stands today with inflation globally seemingly on a downward trajectory (at least in the US and in Europe), bond yields appear to be at or close to their peak, and so we think the negative correlation between bonds and equities should remain.  

If the economic situation was to deteriorate further and the environment for risk assets was to become more challenging again, bonds are expected to provide diversification. If, on the other hand, the economic environment remains supportive, both equity and bonds would add value to multi-asset portfolios. Bonds might not necessarily experience higher direct prices, but current levels of yield would generate a much higher level of income return within portfolios.  

How this is reflected in Nutmeg portfolios 

From the perspective of the Nutmeg investment team, we have increased our exposure to bonds in the last few weeks as we think the yields on offer from mid (three to seven years) and long-term bonds may have peaked. We expect multi-asset bond and equity portfolios to be efficiently diversified, leaving behind the unattractive period of positive bond-equity correlation.   

Risk warning 

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.